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Transaction Exposure
T Questions
Foreign exchange exposure
1.
Exposure types
2.
Is there any difference between translation exposure and transaction exposure? Explain.
Translation exposure measures accounting (book) gains and losses from a change in exchange rates.
Transaction exposure measures cash (realized) gains and losses from a change in exchange rates.
Chapter 8
Transaction Exposure
133
Tax exposure
4.
What is tax exposure and how does it relate to the triumvirate of transaction, operating, and
translation exposure?
Tax exposure is separate from the triumvirate of transaction, operating, and accounting exposure
because it basically the tax consequences of a gain or loss caused by this triumvirate. Transaction
exposure is a cash loss and so results in a tax savingsin the sense that a lowering of profits because
of a transaction loss lowers income taxes, other things being equal. Any loss from operating exposure
is difficult to measure; a resultant drop in market value of a MNEs shares has no tax consequences
for the companyalthough it may have tax consequences for investors holding the shares. To the
extent that operating exposure causes a lowering of corporate profits in future years, taxes in those
years are reduced. Translation exposure is a measurement loss, rather than a cash loss, and so has no
tax consequences.
Hedging
5.
What is a hedge?
A hedge is the acquisition of a contract or a physical asset that will offset a change in value of some
other contract or physical asset. Hedges are entered into to reduce or eliminate risk.
Exhibit 8.2 in the text shows two normal distributions about a mean called expected value.
(a) The areas toward the center of the distributions where the hedged line is higher than the
unhedged line, implies that a greater proportion of expected values will be near the expected
mean value when the cash flows are hedged. Variability of expected results is reduced.
(b) The areas toward the outlying edges of the distributions, where the unhedged line is higher
than the hedged line, imply that a greater likelihood exists for significantly higher cash flows
as well as significantly lower cash flows than exist when the cash flows are hedged.
(c) Hedging is not cost free; something is paid to obtain the hedge. Hence the expected value for
hedged cash flows should be that of the unhedged cash flow less the cost of the hedge. Thus one
might argue that the mean expected value of the hedged cash flow should be to the left of that for
the unhedged cash flow. (No reason exists for the mean cash flow of the hedged flows to be to
the right of that for the unhedged cash flows.)
Investor expectations
7.
Proponents of the efficient market hypothesis argue that an MNE should not hedge because investors
can hedge themselves if they do not like the foreign exchange risks carried by the firm. Assess this
argument.
Proponents of the efficient market hypothesis believe that the current market price of a MNEs shares
of stock fully and appropriately discounts all the risks of the firm, including foreign exchange risk,
and that the firm should not pay the cash cost of hedging because investors can individually hedge or
not as they see fit, and that the present share price already reflects this risk. These proponents also
argue that the propensity to carry risk is different for management than for shareholders, and that risk
hedging is often undertaken by management to protect its own interests, which differ from the
interests of shareholders. Lastly they argue that management is more likely to hedge accounting risks,
which are more precisely measured, than operating risks, which are conceptual and deal with future
expectations.
134
The argument that management might appropriately hedge its foreign currency risks is based on the
logic that management has firsthand knowledge of foreign currency risks, that the nature and
magnitude of these risks change from day to day (or at least month to month), and that the specifics
of such risks cannot be known (and so discounted) by the impersonal forces of an efficient market.
Other arguments in favor of hedging include improved cash flow management for the firm and the
need to preserve liquidity for debt service and/or unexpected variations in near-term cash flows.
Creating transaction exposure
8.
Identify and create a hypothetical example for each of the four causes of transaction exposure.
Assume a hypothetical U.S. company named Smith Company.
(a) Purchasing or selling on open account. Smith Company sells goods to a buyer in Great Britain
with the sale denominated in British pounds sterling and payment due in 60 days. When Smith
Company receives the pounds sterling 60 days after the sale, the U.S. dollar value of those
pounds may be less, or more, than was expected at the time of sale.
(b) Borrowing and lending. Smith Company finds that it can borrow Swiss francs at 4% per annum
interest, and exchange them for the needed U.S. dollars, whereas borrowing dollars in the U.S.
will cost 7% per annum. Hence it borrows Swiss francs for one year in order to save on the
interest cost. One year hence the Swiss franc has strengthened against the dollar by more than the
3% interest differential, and the Swiss franc borrowing ends up costing more than 7% in U.S.
dollar terms.
(c) Owning an unperformed foreign exchange forward contract. Believing that the Japanese yen will
weaken within three months, Smith Company decides to speculate by selling yen forward. It
hopes to profit by buying the yen to deliver against this forward sale at a cheaper exchange rate
in three months. In fact the yen strengthens and Smith Company must buy yen to cover its
forward yen obligation at a price higher than will be received via the forward sale.
(d) Acquiring assets or incurring liabilities denominated in foreign currencies. Having excess cash
and faced with euro interest rates of 8% and U.S. rates of 5%, Smith Company invests the cash in
euro money market obligations. At maturity the euro has weakened by more than three
percentage points and Smith Company ends up earning in dollars less than the 5% it could have
earned by investing in a U.S. dollar asset.
Cash balances
9.
Why does the holding of foreign currency cash balances not lead to transaction exposure?
Transaction exposure arises from the payment of one currency to a party wanting, in the end, a
different currency. Thus a movement of currency value from one currency to another is required.
Foreign currency cash balances held for operating purposes by a foreign subsidiary are not inherently
intended for exchange for another currency, nor is such an exchange required. Hence they do not
create transaction exposure. (They do, however, create translation exposure.)
Chapter 8
Transaction Exposure
135
2.
To what degree did he limit the upside and downside exposure of the transaction by hedging one-half
of it? Do you agree with his critics that he was speculating?
Ruhnau did not effectively manage his exchange rate risk. A completely uncovered position would
have no upper or lower limit to its exposure. A position which is one-half covered would still have no
limit to it upside or downside, only half the slope or rate of movement as the totally uncovered
position. A call option on dollars (or put option on marks) would have placed an absolute upper limit
on how much Ruhnau and Lufthansa would have to pay to settle the Boeing purchase.
It is difficult to truly agree with the argument that he was speculating. Ruhnau was indeed trying to
manage or hedge the exposure, but his strategy was definitely flawed. To accuse him of speculating
on the component which was covered with the forward contract is to not understand the concept of
transaction exposure and how a short position in a foreign currency could potentially cause severe
monetary losses or excessive expenses in the event the foreign currency appreciated significantly
before cash settlement.
136
3.
Chapter 8
Transaction Exposure
Values
Rp1,650,000,000
9,450
9,400
9,950
$168,000.00
At Spot
$174,603.17
Values
Risk
Assessment
$174,603.17
Risky
$175,531.91
Risky
$165,829.15
Risky
$165,829.15
Certain
20.1%
Alternatives
1. Remain Uncovered.
Settle A/R in 90 days at current spot rate.
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
The cost of forward cover, 20.1%, is indicative of the artificial interest rates used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
forward cover.
137
138
Values
$80,000,000
$20,000,000
3.148
4.00%
14.00%
3.4507
Risk
Values Assessment
Analysis
Net exposure at time of cash settlements:
One year A/R due
One year A/P due
Net exposure
$80,000,000
$(20,000,000)
$60,000,000
Certain
This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of
the Brazilian real, that it has traditionally suffered from rapid depreciation and occasional devaluation,
a net long position in dollars by most Brazilian companies is considered a very good thing.
Cash settlement of the net position:
Brazilian reais in one year at current spot rate
R$188,880,000.00
Risky
R$207,041,538.46
Certain
In this case, however, because the real is selling forward at a considerable discount, the net long
positionif sold forwardyields considerably more real than the current spot rate. It should also
be noted, however, that if the real were to fall considerably over the coming year, by remaining
unhedged Embraer would enjoy greater reais returns.
Values
8,500,000
120.60
47.75
2.5257
2.4000
2.6000
8.000%
1.500%
4.850%
12.00%
Values
(120.60/47.75)
Spot
Rate (Rp/$)
Risk
Assessment
Risky
3,541,666.67
2.4000
Risky
3,269,230.77
2.6000
Risky
3,541,666.67
2.4000
Certain
139
(Continued)
Transaction Exposure
3,365,464.34
Chapter 8
140
8,500,000.00
0.9926
8,436,724.57
2.5257
3,340,411.26
1.0600
3,540,835.94
Certain
8,500,000.00
2.5257
3,365,464.34
163,225.02
1.0600
173,018.52
3,538,482.87
Evaluation of Alternatives
The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.
Certain
Chapter 8
Transaction Exposure
141
Values
30,000,000.00
$1.2186
$1.2170
$1.2210
$1.1800
4.000%
4.400%
$1.2174
5.600%
6.400%
9.600%
Hedging Alternatives
Values
1. Remain Uncovered, settling A/R in 90 days at market rate
(20 million euros/future spot rate)
If spot rate in 90 days is same as current $36,558,000.00
Risk
Assessment
Risky
Risky
Risky
Risky
$36,630,000.00
Certain
Certain
30,000,000.00
0.9843 1/(1 + (0.064 90/360))
29,527,559.06
$1.2186
$35,982,283.46
1.0240
1 + (0.0960 90/360)
Certain
Evaluation of Alternatives
The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost
of capital as the reinvestment rate (carry-forward rate).
142
Values
4,000,000.00
1.2000
1.2180
4.200%
1.0800
3.400%
9.800%
a)
Value
b)
Certainty?
Certain;
Locked-in
Chapter 8
Transaction Exposure
143
Value
Do Nothing $4,800,000.00
Sell A/R forward $4,872,000.00
Buy Put Option $4,152,801.60
Minimum is
guaranteed;
could be
greater.
Certainty?
Risky
Certain
Minimum
144
Values
8,000,000.00
108.20
106.20
1.250%
4.000%
108.00
2.500%
9.800%
a) Value
b) Certainty
Very uncertain;
Risky
Very uncertain;
Risky
Certain;
Locked-in
Chapter 8
Transaction Exposure
145
8,000,000
0.9938
7,950,311
108.20
$73,477.92
1.05
$77,078.33
1 + (0.0980 180/360)
$74,074.07
$1,939.00
$76,013.08
Maximum cost
guaranteed;
could be
less.
Value
$73,937.15
$75,329.57
$77,078.33
$76,013.08
Certainty?
Risky
Certain
Certain
Maximum
c) If Tek wishes to take a reasonable risk (definining reasonable is another issue), and has a directional view
that the yen may be depreciating (falling) versus the dollar over the coming 6-month period, somewhere
below the option strike rate of 108/$, then Tek might consider purchasing the call option. If Tek is a bit
more risk adverse, the forward rate is relatively attractive compared to the money market hedge.
146
Values
1,500,000
1.8418
9.800%
1-month
1.8368
4.000%
6.500%
4-month
1.8268
4.125%
6.500%
1.85
$0.006
1.85
$0.012
a) Value
b) Certainty
$2,762,700.00
Risky
$2,740,200.00
Risky
If Tek wins the bid, it will be long foreign currency, having a 1.5 million
pound position which is first backlog then an A/R.
If and when Tek is awarded the bid, it would have 4 months (120 days)
until cash settlement of the 1 million pound position.
1. Do NothingRemaining Uncovered
Wait 120 days and exchange pounds for dollars spot
If the ending spot rate is the same as current spot rate
If the ending spot rate is the same as the 4-month forward rate
It could, however, be much lower.
$2,740,200.00
1,500,000
0.9788
1,468,189
1.8418
$2,704,110.93
1.0327
$2,792,445.22
$2,775,000.00
$18,000.00
588.00
$18,588.00
$2,756,412.00
1 + (0.098 120/360)
Minimum;
Could be More
The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bids award.
The advantage of the option is if Tek does not win the bid, the option can easily be sold.
Transaction Exposure
Chapter 8
Certain Value
If Tek Wins Bid
147
148
Values
5,000,000.00
7.4793
7.4937
4.000%
4.780%
6.500%
Could be more
7.50
2.500%
9.800%
Hedging Alternatives
This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of
sales will occur, and therefore what Teks actual long position in Swedish krona will be.
Value
Certainty?
1. Do NothingRemain Uncovered.
The ending spot rate at the time of settlement
could be nearly anything.
If the ending spot rate is the same as current spot rate (SKr/$) $668,511.76
Risky
If the ending spot rate is the same as forward (SKr/$)
$667,227.14
Risky
$667,227.14
Certain
Chapter 8
Transaction Exposure
If not exercised
(random choice)
7.24
5,000,000.00
$690,607.73
$16,712.79
409.46
$17,122.26
$16,712.79
409.46
$17,122.26
$649,544.41
Minimum
$673,485.48
The money market hedge provides the highest certain US dollar receipts. (This is again a result of the
significant increase in relative value arising from carrying-forward the dollars at Teks WACC.)
If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr
would have to fall to about SKr7.24 (shown above) in order for the put option to yield roughly the
same amount of US dollars as the money market hedge.
149
150
Values
SFr. 5,000,000
1.2462
1.2429
4.000%
3.750%
1.25
$0.015
9.80%
1.22
Value
Certainty?
If the ending spot rate is the same as current spot rate (SFr/$)
$4,012,197.08
Risky
$4,022,849.79
Risky
1. Do NothingRemain Uncovered.
Realistically, the ending spot rate could vary between SFr1 and SFr2 per $.
2. Sell Swiss francs forward
Sold forward 3-months at forward rate (SFr/$)
$4,022,849.79
Certain
Chapter 8
Transaction Exposure
If exercised
If not exercised
1.22
SFr. 5,000,000
$4,098,360.66
$75,000.00
1,837.50
$76,837.50
$75,000.00
1,837.50
$76,837.50
$3,923,162.50
Minimum
$4,021,523.16
Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however,
Tek wishes to accept some degree of currency risk, and believes in the direciton of a stronger
SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.22/$. This
is still not superior to the Money Market Hedge. (The ending spot rate would need to be
SFr1.20/$or stronger to end up superior to the Money Market Hedge.)
151
152
Values
4.70
4.71
4.72
4.74
090 days
3,000,000
Forward
Discount
0.85%
0.85%
0.84%
91180 days
2,000,000
1,000,000
Chapter 8
Transaction Exposure
Values
8,400,000
7.0000
7.1000
14.000%
6.000%
20.000%
Cost
Certainty
$1,050,000.00
Risky
Expected rate
$1,150,684.93
Risky
$1,312,500.00
Risky
$1,183,098.59
Certain
7,850,467.29
$1,121,495.33
1.10
$1,233,644.86
Certain
8.0000
7.3000
6.4000
The second choice, the forward contract, results in the lowest cost alternative among
certain alternatives.
153
154
Values
7,000,000
33.40
32.40
1.500%
6.500%
not available
Cost Certainty
$209,580.84
Risky
$216,049.38
Risky
$216,049.38
Certain
7,000,000
0.9963
6,973,848
33.40
$208,797.85
6.500%
1.0163
$212,190.81
Certain
The currency risk is eliminated, but since Matt Morita would have to exchange the money upfront, it requires Matt Morita to increase his debt outstanding for the entire 3 months.
Forward contract hedge is probably the best acceptable alternative.
Chapter 8
Transaction Exposure
155
Values
12,500,000
120.23
119.73
118.78
117.21
8.850%
12.500%
4.500%
Josh Miller should compare two basic alternatives, both of which eliminate the currency risk.
1. Allow the discount and receive payment in Japanese yen in cash
Account recievable (yen)
Discount for cash payment up-front (4.500%)
Amount paid in cash net of discount
12,500,000
(562,500)
11,937,500
120.23
$99,288.86
2. Not offer any discounts for early payment and cover exposure with forwards
Account receivable (yen)
30-day forward rate
Amount received in cash in dollars, in 30 days
12,500,000
119.73
$104,401.57
0.9897
$103,325.27
Josh Miller should politely decline Yokasas offer to pay cash in exchange for cash payment.
156
Values
6,000,000
14.000%
10.00
10.40
Call Option
10.00
2.000%
Put Option
10.00
3.000%
United States
6.000%
5.000%
Morocco
8.000%
7.000%
Values
Certainty
6,000,000
10.00
$600,000.00
Uncertain.
6,000,000
10.40
$576,923.08
Uncertain.
Chapter 8
Transaction Exposure
6,000,000
10.40
$576,923.08
Certain.
3. Money market hedge. Exchange dollars for dirhams now, invest for six months.
Account payable (dirhams)
6,000,000.00
Discount factor at the dirham investing rate for 6 months
1.035
Dirhams needed now for investing (payable/discount factor)
5,797,101.45
Current spot rate (dirhams/$)
10.00
US dollars needed now
$579,710.14
Carry forward rate for six months (WACC)
1.070
US dollar cost, in six months, of settlement
$620,289.86
Certain.
6,000,000.00
10.00
2.000%
$12,000.00
$600,000.00
12,840.000
$612,840.00
Maximum.
The lowest cost certain alternative is the forward. If Wilmington were to expect the dirham to
depreciate significantly over the next six months, it may choose the call option.
157
158
Values
7,030,000,000
(1,000,000,000)
6,030,000,000
1,200
1,260
25.00%
Call Option
1,200.00
3.000%
Put Option
1,200.00
2.400%
United States
4.000%
6.000%
Korea
16.000%
18.000%
Values
Certainty
6,030,000,000
1,200
$5,025,000.00
Uncertain.
6,030,000,000
1,260
$4,785,714.29
Uncertain.
Chapter 8
Transaction Exposure
6,030,000,000
1,260.00
$4,785,714.29
Certain.
3. Money market hedge. Exchange dollars for won now, invest for six months.
Account payable (won)
6,030,000,000
Discount factor at the won interest rate for 6 months
1.080
Won needed now (payable/discount factor) 5,583,333,333.33
Current spot rate (won/$)
1,200.00
US dollars needed now
$4,652,777.78
Carry forward rate for six months (WACC)
1.125
US dollar cost, in six months, of settlement
$5,234,375.00
Certain.
$4,613,618.97
169,593.75
$4,783,212.72
The forward contract provides the lowest cost hedging method for payment settlement. If, however, the firm believes
the ending spot rate will be Won 1307/$or higher, the call option hedge could prove lower cost. This would require the
firm, however, to accept the foreign exchange risk and suffering the higher cost of the call option hedge in the event
their spot rate expectations proved incorrect.
159
160
Values
20,000,000
118.255
$169,126.04
90
16.0%
2.0%
Forward Rate
117.760
116.830
112.450
Premium
5.04%
4.88%
5.16%
United States
4.8750%
4.9375%
5.1875%
Japan
0.09375%
0.09375%
0.31250%
Purchased options
3-month call option on yen
3-month put option on yen
Strike (yen/$)
118.000
118.000
Premium
1.0%
3.0%
Chapter 8
Transaction Exposure
161
Values
Certainty
20,000,000
118.255
$169,126.04
Uncertain.
20,000,000
116.830
$171,188.91
Certain.
1. Remain uncovered.
Account receivable (yen)
Possible spot rate in 90 days (yen/$)
Cash settlement in 90 days (US$)
2. Forward market hedge.
Account receivable (yen)
Forward rate (won/$)
Cash settlement in 90 days (US$)
3. Money market hedge.
Account receivable (yen)
Discount factor for 90 days
Yen proceeds up front
Current spot rate (won/$)
US dollars received now
Carry forward at Aqua-Pures WACC
Proceeds in 90 days
4. Put option hedge. (Need to sell yen = put on yen)
Option principal
Current spot rate (won/$)
Premium cost of option (%)
Option pm (principal/spot rate % pm)
If option exercised, dollar proceeds
Less Pm carried forward 90 days
Net proceeds in 90 days
20,000,000
1.00523 1 + ((0.0009375 + .02) 90/360)
19,895,858
118.255
$168,245.38
1.0400
1 + (0.16 90/360)
$174,975.20
Certain.
20,000,000
118.255
3.000%
$5,073.78
$169,491.53
(5,276.732)
$164,214.79
The put option does not GUARANTEE the company of settling for the booked amount.
The money market and forward hedges do; the money market yielding the higher proceeds.
b) Breakeven rate between the money market and the forward hedge is determined by the
reinvestment rate:
Money market, US$up-front
$168,245.38
Forward contract, US$, end of 90 days
$171,188.91
(1 + x)
101.750%
$168,245 (1 + x) = $171,189
x
1.74954%
For 90 days
Breakeven rate, % per annum
6.998%
162
Values
1,560,000
$1.2340
$1.2460
$1.2000
$1.2600
Hedged
the Minimum
70%
1,560,000
70%
1,092,000
$1.2460
$1,360,632
Hedged
the Maximum
120%
1,560,000
120%
1,872,000
$1.2460
$2,332,512
468,000
$1.2000
$561,600
(312,000)
$1.2000
$(374,400)
$1,360,632
$1,922,232
468,000
$1.2600
$589,680
$1,360,632
$1,950,312
$2,332,512
$1,939,392
$1,943,760
$1,943,760
$2,332,512
$1,958,112
(312,000)
$1.2600
$(393,120)
This is not a conservative hedging policy. Any time a firm may choose to leave any proportion
uncovered, or purchase cover for more than the exposure (therefore creating a net short position) the firm
could experience nearly unlimited losses or gains.
Call Option
3.0%
2.6%
Put Option
2.0%
1.2%
June Receivable
2,000,000
Sept
Receivable
2,000,000
2,000,000
$1.1060
$2,212,000
1.03
$2,278,360
2,000,000
$1.1130
$2,226,000
$2,226,000
$4,504,360
Transaction Exposure
Chapter 8
(Continued)
163
164
2,000,000
1.02
1,960,784
$1.1000
$2,156,863
1.06
$2,286,275
2,000,000
1.04
1,923,077
$1.1000
$2,115,385
1.06
$2,242,308
$4,528,582
2,000,000
$(44,000)
1.06
$(46,640)
2,000,000
$(26,400)
1.06
$(27,984)
$2,200,000
1.03
$2,266,000
$2,200,000
$2,200,000
$4,391,376
2,000,000
???
2,000,000
???
Event
February 1
March 1
June 1
August 1
September 1
Spot Rate
Forward Rate
Days Forward
of Forward Rate
1.7850
1.7465
1,000,000
1.7689
1.7840
1.7290
1.7771
1.7381
210
180
1.7602
1.7811
90
30
Analysis
$1,729,000
$1,768,900
$(39,900)
b. The vlaue of the foreign exchange gain (loss) will depend upon when Leo actually purchases the forward contract. Because
many firms do not define an exposure as arising until the date that the product is shipped (loss of physical control over
the goods) and the sale is booked on the income statement, that is a common date for the purchase of the forward contract.
Transaction Exposure
Value as settled
Value as booked
FX gain (loss)
Chapter 8
a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, and the shipment
is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement,
the difference being the foreign exchange gain (loss).
(Continued)
165
166
$1,760,200
$1,768,900
$(8,700)
A more aggressive alternative is for Leo to purchase the forward contract on the date that the contract was signed, March 1, lockingin Pixels US dollar settlement amount a full 90 days earlier in the transaction exposures life span.
Forward contract purchased on March 1
Value of forward settlement 1 million pounds @ $1.7381/pound
Value as booked
1 million pounds @ $1.7689/pound
FX gain (loss)
$1,738,100
$1,768,900
$(30,800)
Note that in this case if Leo had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would
have been even greater, although fully hedged. The difference is of course the result of the forward rate changing with spot rates
and interest differentials.
Value
3,000,000
1.7620
1.7550
6.000%
8.000%
8.000%
14.000%
1.75
1.500%
12.000%
1.7850
Rate ($/pound)
Proceeds
$1.7620
$1.7550
$1.7850
Rate ($/pound)
$5,286,000.00
$5,265,000.00
$5,355,000.00
Proceeds
$1.7550
$5,265,000.00
Proceeds
1.71
1.000%
$5,107,246.38
167
1.0300
$5,260,463.77
(Continued)
Transaction Exposure
3,000,000.00
0.9662
2,898,550.72
Chapter 8
168
Option premium
Notional principal of option (pounds)
Spot rate ($/pound)
Option premium, US$
Carry-forward factor, WACC, for 90-days
Total premium cost, in 90-days
$5,250,000.00
(81,668.70)
$5,168,331.30
$5,130,000.00
(54,445.80)
$5,075,554.20
$1.7825
$5,347,500.00
(81,668.70)
$5,265,831.30
$1.7732
$5,319,600.00
(54,445.80)
$5,265,154.20
Analysis: Maria Gonzalez would receive the most certain US$from the forward contract, $5,265,000; the money
market hedge is less attractive as result of the higher borrowing costs in the UK now. The two put options yield
unattractive amounts if they had to be exercised. As shown, the $1.75 strike price put option would be superior to the
forward if the ending spot rate was $1.7825 or higher; the $1.71 strike price would be superior to the forward if the
ending spot rate were $1.7732 or higher.
1.0560
1.5900
122.43
1.0560
1.5900
122.43
1.0560
1.5900
122.43
1.0250
1.5875
120.85
1.0250
1.5875
120.85
1.0250
1.5875
120.85
1.0660
1.5600
126.00
1.0660
1.5600
126.00
1.0660
1.5600
126.00
1.0480
1.6000
122.50
2,340,000
1,780,000
125,000,000
a)
Settled at Forecast
$23,400
$(53,400)
$(28,928)
$(58,928)
2,340,000
1,780,000
125,000,000
b)
Settled at Forward
$(72,540)
$(4,450)
$13,349
$(63,641)
2,340,000
1,780,000
125,000,000
c)
Forwards on Points
$(45,630)
$6,67
$13,34
$(25,606)
Part c) Positions
Paying points
Paying points
Receiving points
(Continued)
169
Assumption
Transaction Exposure
Assumption
Chapter 8
170
Uncovered
Settled at Forecast
$13,622,232
7,300,000
6,322,232
(8,854,451)
$4,767,781
100% Forward
Cover
$13,622,232
7,300,000
6,322,232
(8,854,451)
$4,767,781
Forward Cover
Based on Points
$13,622,232
7,300,000
6,322,232
(8,854,451)
$4,767,781
9%
(1,226,001)
(248,750)
(58,928)
$3,234,102
(1,226,001)
(248,750)
(63,641)
$3,229,389
(1,226,001)
(248,750)
(25,606)
$3,267,424
40%
(1,293,641)
$1,940,461
(1,291,755)
$1,937,633
(1,306,969)
$1,960,454
1,000,000
$1.940
1,000,000
$1.938
1,000,000
$1.960
65%
Tridents EPS is highest in part c), where it determined its forward cover by whether it would receive or pay the forward points. In part c), for both the
euro and the pound, Dayton is paying the points, and would therefore decide to cover 50% of the exposure with forwards (the yen is receiving the
points, and is 100% covered with forwards). The foreign exchange loss for the pound is smaller in part c) because the pound moved in the companys
favor. Although the euro moves against the firm, the loss is not as large as what would occur under the forward contract.
Chapter 8
Transaction Exposure
Value
$50,000,000
8.400%
25.00
42.00
$50,000,000
4,200,000
$54,200,000
25.00
1,355,000,000
1,250,000,000
105,000,000
$50,000,000
4,200,000
$54,200,000
42.00
2,276,400,000
(1,355,000,000)
921,400,000
171